Economics: Efficient market concept

Charles Ray's image for:
"Economics: Efficient market concept"
Image by: 

The efficient market theory of economics posits that financial markets reflect all known information, and that they will change instantly to reflect any new information. All securities investors have access to the available information when making market decisions, therefore, it is believed impossible for an individual investor to outperform the market except through blind luck (or illegal insider trading).

The efficient market theory was first expressed by French mathematician Louis Bachelier in 1900, and was developed fully by Professor Eugene Fama of the University of Chicago in the 1960s.

In general, according to this theory, a monkey selecting stocks at random would have as much chance of making a profit as would an experienced securities trader. Thus, any investor should be able to perform as well in the market as the professional traders. While many on Wall Street are strong proponents of the efficient market theory as a description of rational financial market behavior, it is not without its detractors.

International financier George Soros says that the whole idea of the efficient market theory is an academic ivory tower fantasy. He and many other economists believe that it fails to take into account the role that irrational 'human behavior' plays in securities trading.

Some economists even believe that this blind faith in rational markets caused many not to see the impending bursting of the mortgage bubble and was a cause of much of the current global financial crisis. Roger Lowenstein says that an upside of the current recession is that it could finally drive a stake through the heart of this theory.

While opponents of the efficient market theory might be overstating its role in the current financial crisis, the view that universal availability of information puts all investors on an equal footing is discredited by the fact that some, like Warren Buffett, have become extremely wealthy by constantly outperforming the market. It also does not take into account that even when everyone has the same information, not all will interpret it in the same way. In the 1980s, when securities prices began a free-fall, many investors immediately dumped their holdings, and took a beating. Others took advantage of the depressed prices to buy more, and when the markets recovered, made money. A major weakness of the efficient market theory is that it assumes rational behavior on the part of human beings who are often subject to making irrational decisions.

More about this author: Charles Ray

From Around the Web